Bill Morneau’s backpedalling recalls past tax debacles

Tax lawyer David J. Rotfleisch says the tax reversal would have likely occurred in a U.S. scenario as well

TORONTO – The recent backpedaling on tax changes by the Liberal government and Finance Minister Bill Morneau has been fascinating to Canadian accountants and tax lawyers from both a tax and political point of view. We have seen as many tax announcements and changes, outside of a budget, as I can recall in my 30 years as a tax lawyer.

However, one of the aspects of the process that amounted to the Federal Liberals effectively eliminating all of the July proposals, is how much it differed from the U.S. system, and how the final result is probably similar to what would have been produced by the U.S. Congress.

I had considerable response to an earlier opinion piece, including from a senior Liberal MP who was completely opposed to what his party was proposing, which was interesting. This Liberal caucus opposition to the changes was common and well-covered by the media.

That led me to think about the U.S. system where such measures, broadly opposed by both members of the ruling party, the minority party, and a wide segment of the public, would never see the light of day.

Accountants with sufficient grey hair may remember that, in 1971, the Canadian government enacted a tax on corporate retained earnings that was very similar to what our government proposed last July. Those changes occurred after a royal commission had reported to Parliament with what became Tax Reform, a plan for a radical transformation of Canada’s tax system, effective January 1, 1972.

Those 1972 tax changes were repealed only one year after they were implemented due to their overwhelming complexity and plain unworkability.

It seems as though there is a source of confusion in this country among taxpayers — but also, surprisingly, with the Minister of Finance — as to how the Canadian tax system actually works as far as integration, a keystone of the Carter Commission.

As accountants we know that Canada already imposes a tax on passive income in a corporation called Part IV tax — this brings the tax on passive income up to just above the highest marginal personal rate and encourages owners to dividend out the income to themselves in exchange for a refund of the Part IV tax to the Corporation.

Take money out, pay tax at top tax rates. Leave money in the corporation, pay tax at the same top rate, thanks to integration.

What’s now being proposed adds an additional level of complexity. Business owners will be required to track dollar amounts reinvested in their corporations and then allocate them to passive versus active, but only once they pass the $50,000 threshold.

This will have the effect of driving up professional fees for accounting services and increasing compliance costs for the CRA itself when it comes time to audit taxpayers.

So, what tax planning evil is being targeted?

Say a small business earns $100 and retains the income. Tax of $15 is paid on active income. If the funds had been withdrawn by the shareholder, about another $35 of tax would have been paid by the owner-manager. So, this $35 of deferred tax is left in the corporation to earn passive income (that is, taxed at top rates). That is the “tax abuse” that is the subject of these new rules.

So, after all the backtracking by Bill Morneau, what changes does this leave? Some form of offensive against income splitting or “sprinkling” that will be introduced in the future, probably in the next federal budget.

The vigorous response from the public and professional advisors has been very successful. There are still elements of the proposals that have survived and will create compliance burdens on small business taxpayers, but the attenuated proposals are far less damaging than the original July release.

Which brings us full circle to the U.S. What would have happened with such a comprehensive set of unpopular changes?

Probably nothing would have made it out of Congress. If there were any remnants of the proposals that did make it into a Bill supported by both Houses, the changes might well have resembled what is left of the Liberal wish list: complex rules targeting three per cent of private corporations.

David J Rotfleisch, CPA, JD is the founding tax lawyer of Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law firm. With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax litigation. Visit Taxpage.com and email David at david@taxpage.com